Implications Exchange Rate Changes for the Operations of UK Multinationals

Paper Type:  Essay
Pages:  7
Wordcount:  1651 Words
Date:  2022-05-09
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Introduction

The exchange rate is the value at which a currency is traded for another. It is essential in international trade since it influences the competitiveness of a company, the value of exports, imports, capital inflows, and outflows. The UK uses the Sterling Pound as its official currency hence the fluctuations of the exchange rate between the Pound and other currencies affect UK multinational companies such as GlaxoSmithKline, Barclays, HSBC, Old Mutual, Tesco, Sainsbury, among other companies. The value of the domestic currency and its variation are determined by the exchange rate regime adopted by the country. Exchange rate regimes include fixed and floating regimes.

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Fixed Exchange Rate Regime

This is where the country maintains that value of its currency at a given level against another currency or a basket of currencies. In this case, the exchange rate is not allowed to fluctuate. It requires the government to intervene to keep the currency's value at the desired level. For instance, if the Sterling is falling below the desired value, the Bank of England would intervene by buying the Sterling using its foreign reserves. This reduces the supply of the Sterling and increases the supply of the foreign currency thereby increasing the exchange rate. The regime reduces the foreign currency risks and protects the economy from adverse changes in the exchange rate. The purely fixed exchange rate regime is rarely used in the modern era due to its anti-trade effects. It is also facilitated by WTO's condition for its members to allow the exchange rate to fluctuate freely. Some countries have fixed the exchange rates but allow for deviation within a target range.

Floating Exchange Rate Regime

It is a regime where the exchange rate is influenced by the market forces of demand and supply. The equilibrium exchange rate is determined by the intersection of the demand and supply of the currency as shown in figure 1 below. If there is an increase in the supply of Sterling with no change in demand, the value of the Sterling will decline from E0 to E1 as shown in the figure below. However, an increase in the demand for the Sterling will lead to a rise in the value of the Sterling.

Quantity of Pounds

The UK adopted the free-floating exchange rate regime in 1976 implying that the value of the Sterling is influenced by demand and supply in the foreign exchange market. This implies that UK multinational firms are exposed to the foreign currency risk. However, the Bank of England occasionally intervenes through open market operations and other monetary policies to prevent or correct adverse fluctuations. None of the countries operate a free-floating exchange rate regime. Most countries operate a managed floating exchange rate regime where the exchange rate fluctuates daily but is manipulated by the respective central banks through buying and selling of currencies in the foreign exchange market. For instance, if the value of the UK Pound has declined below the level the Bank of England desires, it will buy Pounds suing its foreign reserves.

Implications Exchange Rate Changes for the Operations of UK Multinationals

Marketing Decisions

The changes in exchange rates affect the price competitiveness of UK products both in the UK and in international markets. A depreciation of the local currency enhances the competitiveness of local goods and services. In the global market, UK companies price their goods either in UK Pounds, US dollars or the Euro. A drop in the value of the pound implies that consumers of UK products in America will need fewer US dollars to purchase the UK products. It means that the UK products become relatively cheaper than other foreign products hence increasing their demand. Most of the products affected by the decline in the value of the UK Pound are consumer products with price-elastic demands. On the other hand, the appreciation of the Sterling makes UK goods relatively more expensive than products of foreign firms.

Several UK multinationals benefitted from the weakening of the Pound following the Brexit vote in 2016. The biggest beneficiaries were multinationals with significant earnings from overseas markets (Fletcher & Kollewe, 2016). UK fashion label Burberry was one of the biggest winners since both its UK and foreign revenues increased due to the depreciation of the pound. The weaker Pound attracted more tourists thereby leading to a 30% increase in revenues at Burberry's London stores (Fletcher & Kollewe, 2016). More than 85% of Burberry's total revenues are outside the UK market (Fletcher & Kollewe, 2016) hence the weakening of the Sterling had a significant positive impact on its earnings.

GlaxoSmithKline was also a significant beneficiary of the depreciation of the Sterling Pound in 2016 and 2017. Despite being a UK-based company, most of GlaxoSmithKline's revenues are outside the UK. In 2016, the UK market contributed only PS1.056 billion (3.8%) of its total PS27.889 billion (GlaxoSmithKline, 2016, 172). In the second quarter of 2017, GlaxoSmithKline's revenues grew by 12% in Sterling terms and 3% in constant exchange rate terms (GlaxoSmithKline, 2018). During the year 2017, the company's revenues increased by 8% in Sterling terms and 3% in CER terms (GlaxoSmithKline, 2018, 31).

Production Decisions

Multinational companies are faced with exchange rate considerations in their production decisions. According to Shepherd, Silberston & Strange (2012, 115), multinational corporations base their production decisions on the cost of production in a country, inflation, and the exchange rate. Most UK multinational corporations have established manufacturing units outside the UK to exploit the low costs of production. The appreciation of the Sterling is one of the factors that contributed to shifting production from the UK to other countries. A high Sterling exchange rate implies that the cost of production and distribution of the company's products is higher than when the market is supplied from a country where the exchange rate is lower. For instance, Burberryhas established several manufacturing plants in China to exploit the low cost of production (Cadwalladr, 2012). China has manipulated its exchange rate to make Chinese exports more competitive. GlaxoSmithKlinealso has more than 80 manufacturing plants in different countries. It considers the cost of producing and distribution to determine the amount of production allocated to each of the manufacturing locations. The foreign exchange rate is one of the factors that affect the cost of servicing its global market (Sitkin & Bowen, 2013). However, being a pharmaceutical company, GlaxoSmithKline rarely switches production in response to foreign exchange rate fluctuations due to the administrative and regulatory constraints (Shepherd, Silberston & Strange, 2012, 116). For instance, Italy requires the mandatory secondary production of pharmaceutical products hence it is not possible to export finished products from other manufacturing sites (Shepherd, Silberston & Strange, 2012, 116). The US also has restrictions on the location of manufacturing sites for drugs sold in the country.

Financial Decisions

Changes in exchange rates influence financing decisions such as the source of financing, reporting of foreign results as well as remittance of funds (Appleyard & Field, 2017). Globalization has enabled multinational firms to raise funds through the international capital market. Multinational companies source foreign financing when the exchange rate is favorable. For instance, when raising capital in the UK for a subsidiary in the US, the firm must consider the effect of transferring the capital into US Dollars. If the Sterling is weaker, then US subsidiary will get less US dollars than when the Sterling is stronger. Besides, debt financing obligations involve regular interest payments which are subject to foreign exchange fluctuations (Moffett, Stonehill & Eiteman, 2011). For instance, if GlaxoSmithKline raised debt capital in the US for its UK operations, a depreciation of the UK Pound against the US dollar will lead to an increase in the amount of interest payable to the US lenders. To lower the cost of raising finance, GlaxoSmithKline established a subsidiary GlaxoSmithKline Capital Plc which raises capital for the company and all its subsidiaries. It monitors factors such as the exchange rate and interest rate differentials, among other factors, to determine the best source of financing for its capital needs. Besides, the GlaxoSmithKline has listed its stock in both the London and New York Stock Exchanges to reduce financing costs. Aviva Plc has also listed its stock in both the NYSE and the LSE.

Exchange rate fluctuations also affect the value of receivables, payables and cash remittances from subsidiaries to the parent company (Shim & Siegel, 2008). Credit transactions are common in the modern business. If a UK multinational company sells to a foreign customer on credit, it faces foreign currency risk since the exchange rate on the date of transaction differs from the rate on the time the payment is due. If the UK Pound appreciates, the UK firm will get less UK Pounds than it would have received on the date of the transaction. Similarly, multinational firms face foreign currency risks concerning payables denominated in foreign currencies. If the UK Pound depreciates, a UK firm will need to pay more Sterling Pounds to settle a payable denominated in US dollars. As at 31 December 2016, GlaxoSmithKline had trade and other receivables amounting to PS6.026 billion, while its trade and other payables were 11.964 billion (GlaxoSmithKline, 2016, 159). A significant percentage of the receivables and payables were due to foreign operations. Burberry's trade receivables and payables on 31 March 2017 were PS276 million and PS102 million respectively (Burberry, 2017, 126). Most of these receivables and payables were due to or from foreign operations indicating that the two companies faced significant foreign currency risk.

Foreign exchange rate fluctuations also affect decisions to remit cash from foreign subsidiaries to the parent company (Eun & Resnick, 2014). Remitting cash when the Sterling has appreciated against the foreign currency leads to foreign currency losses since the UK parent company receives less Sterling pounds than when the Pound has depreciated (Eun & Resnick, 2014). Finally, fluctuations affect the value of the company's net assets held in foreign subsidiaries. Unfavorable movements in the exchange rate lead to the reduction in the company's net assets thereby causing translation losses. Translation risk cannot be avoided since UK multinationals are required to consolidate the financial statements of all its subsidiaries, including foreign subsidiaries. Burberry recognized a foreign currency translation loss...

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Implications Exchange Rate Changes for the Operations of UK Multinationals. (2022, May 09). Retrieved from https://proessays.net/essays/implications-exchange-rate-changes-for-the-operations-of-uk-multinationals

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